Is petrol producer an empty Shell?

Michael West

While the debate about ‘‘heavy lifting’’ rages over the federal budget, it is timely to look at just how much heavy lifting multinational companies are doing on the tax front.

This is where the big dollars are made – and the big dollars in tax are dexterously sidestepped through transfer pricing: that is, stacking the Australian subsidiaries with debt and costs while funnelling profits out of this country into tax havens.

We have recently seen media coverage of how digital giants Apple and Google pay virtually no tax in Australia, and reports last week exposed shopping centre giant Westfield for paying just 8¢ in the dollar over the past nine years (making use of a trust structure rather than transfer pricing).

Today we turn to Shell in Australia. Suffice to say that Shell has contributed to the Australian economy in a big way over the years. Not quite so big any more, though. Shell Australia has become less an Australian company now than a figurine for its foreign parent.

One corollary of this is that it is paying less tax. Shell, like other large corporations, is mimicking the aggressive tax practices of Google and the multinational new guard, and the implications for Australia’s tax base are menacing.

If you look at Shell’s website, you will find that it calls itself Shell in Australia. It used to be Shell Australia. The word ‘‘in’’ is a small word but powerfully redolent of what has changed. This is no longer an Australian company in mind and management.

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Shell Australia used to publish its financial statements on its website. Now it just provides a link to the accounts of its mother ship, Royal Dutch Shell.

It used to boast a glossy annual report for stakeholders. Now you have to search the ASIC database and fork out $21 a page for the pleasure of finding a profit and loss statement. Shell operatives did not make them available to Fairfax Media, citing ‘‘policy’’.

The whole Shell organisation in this country is run on the basis of global authority delegations cascading down from the board of Royal Dutch Shell. Local board approvals are just window-dressing to satisfy Corporations Law.

Perhaps the best evidence for this can be found in the fact that directors of Shell Energy Holdings Australia Ltd – the upstream company that controls exploration assets such as North West Shelf – held and attended just one board meeting during 2013. Compare that with its partner Woodside, where nine directors attended all six meetings; or Caltex, where eight directors attended eight from eight. This is not to mention all the board committee obligations of Woodside and Caltex directors.

SAL recorded revenue of $21.7 billion, a loss of $108 million and a tax benefit of $38 million. The year before it was a $367 million loss and a tax benefit of $111 million.

SEHAL declared revenue of $US3.7 billion last year, a profit of $US2.2 billion and a tax expense of $US261 million (12 per cent). The year before, profit was $US2.6 billion and tax $US803 million.

In contrast, Woodside paid tax of $769 million on a $2.4 billion profit (32 per cent) and Caltex – with its revenues slightly higher than Shell’s downstream operations – recorded tax of $207 million on a profit of $736 million (28 per cent).

One year’s numbers are a mere snapshot, as tax expenses swing wildly each year, but the numbers are instructive.

Fairfax Media put detailed questions to Shell. It declined to respond but issued a statement saying it had been a ‘‘significant contributor to the Australian economy for over a century’’.

‘‘The company’s interests in Australia generated taxes and royalties of well over $US800 million in 2013, and the company collected $US6.1 billion in excise and other taxes.’’

That Shell uses the term ‘‘collected’’, rather than paid, is acknowledgement that excise is a government impost paid by the consumer of the products. Shell is not paying it out of its own funds.

The debt (gearing) of Shell in Australia is almost twice as high as that of Caltex Australia, which is listed on the ASX and has its mind and management in Australia. It is also far higher than that of its parent, which suggests heavy transfer pricing.

All Shell’s borrowings are arranged centrally. With regard to Shell Australia, the increase in borrowings occurred when the oil price dropped back from record highs and SAL incurred significant losses.

Related party services and products, according to last year’s accounts, show SAL’s purchases of $9.7 billion and sales of $473 million. Related entities were listed as British Virgin Islands, Thailand, Philippines and Singapore; all low-tax jurisdictions.

Comparing SAL’s borrowings with those of Caltex, gearing is around 50 per cent for the former and 30 per cent for the latter. Caltex would survive a rapid increase in the oil price, but Shell would probably have to convert some of its borrowings to equity. In the meantime, however, it is better for Shell global to leave SAL’s debt high and claim there is a significant risk premium in lending to SAL because of its high debt levels, thus extracting more tax-deductable benefits from Australia based on high interest charges.

If you look at Royal Dutch consolidated accounts you find that the consolidated picture on gearing is similar to Caltex.

The offsets are in low-tax countries where borrowings are kept low. It’s all legal, of course, but very convenient for soaking up costs in Australia and thus delivering a lower profit on which less tax or no tax has to be paid.

The accounts for the upstream business SEHAL show $US12.3 billion in borrowings from related parties, finance charges of $US522 million, $US421 million capitalised and $114 million expensed. There were $US584 million in sales to related entities and $US665 million in purchases.

Like Google, Shell has made use of Australia’s regime on research and development, to the tune of $12.7 million in tax concessions.

Unlike the SEHAL board, all directors of SAL are currently resident in Australia. Note that they quote titles that reflect their position in the global downstream business rather than titles that reflect their roles in SAL group companies as Australian legal entities.

As a function of global authority delegations, all of these directors are likely used to taking direction from their global or regional offshore managers. Some, but not all SAL group staff, have direct reporting lines to SAL “directors”. Some SAL group staff have direct reporting lines to offshore managers and only “dotted line” reports to local “directors”. The concept in corporations law is that all staff are accountable to at least one director of the entity that employs them. This is not the case in many multinationals, including Shell.

While SAL has had a much stronger legal entity performance focus, in the lead-up to SAL’s divestment of its downstream business to Vitol, the global nature of reporting structures still raises the question of who are the real directors of SAL and how many offshore global managers might qualify as de facto directors of SAL companies.

Looking to the directors' report, there is a loss of $103.5 million on crude oil and product purchases.

Foreign currency amounts owing to other Shell group companies for inventory purchases appear not to have been hedged.

Shell’s theory is that the cycle time for all players in the market (from purchase to sale) is roughly the same, so all have similar response pressures on price changes. Price to customers will be driven by the $A equivalent of $US posted product prices in Singapore.

The benchmark date for a pricing change may vary depending on type of customer, but generally speaking all players, including Caltex, are buying in $US and effectively selling in $US. Changes in values (from the purchase price to sale price) are theoretically only an exposure on the purchase price plus a margin effect. It is impossible to isolate the currency hedging component from the revenue line but common sense suggests it should be there.

The point is that there may not be any transfer pricing issue embedded in this rather large 2013 currency loss even though the purchase is from a related party. Still, in certain circumstances, trading activity may have the effect of shifting profits realised to low-tax locations.

Trading companies registered in Singapore are subject to lower tax rates than other Singapore incorporated companies.

In order to transfer its downstream business to Vitol, the group has decided to sell them its shares in SAL. The sale does not include SAL’s aviation business (which is owned and run by the Shell Company of Australia) or SAL’s lube oil blending and grease plant in Brisbane which will be converted to bulk storage and distribution facilities (and which will presumably remain in the ownership of the Shell Company of Australia Limited, after the transfer of control to Vitol.

The Shell Company of Australia Limited currently owns Shell’s aviation assets in Australia and also owns goodwill associated with both the aviation business and the lubricants distribution business. The carrying value of these assets does not appear to be included in the disclosure on assets held for sale, as the comments in the relevant note say these figures relate only to unused terminals.

The carrying values of these aviation assets may be too small (or already written down) to warrant further disclosure (there will be no carrying value for own goodwill of the value of the customer list).

SAL’s 2013 impairment charges relate to capital expenditure at the Geelong Refinery. There appears to be no charge for 2013 in relation to the decision to scrap the lubricants blending plant. Scrapping this is probably contingent on sale completion, but it is curious that there is no explanation of this in the accounts even if it is too early to take the effect to the P&L.

Note 9 also shows that SAL (under Vitol ownership) will be granted an exclusive distributor arrangement for the distribution of Shell Lubricants.

There is a gain of $1.5 million disclosed from the sale of plant, but what is interesting is that there is no mention of a sale by SAL of the aviation business, including its tangible assets and goodwill, to another Shell Group company. Similarly, there is also no mention of any transfer of the lubricants distribution business and its goodwill and customer data base, to another Shell Group company.

As the Shell Group needs to have a legal basis for retention and ownership of these assets, this would seem essential. It is hard to imagine that Shell would leave ownership of its lubricants customer list with Vitol. That is, if Vitol doesn’t perform, Shell would need to appoint an alternative distributor.

The failure to mention what is happening may be contingent on the Vitol deal, but most users of these accounts would regard the aviation and lubricants changes to be part of the overall package.

The basic legal tenet is that you can’t offer a distributor licensing agreement to someone to operate or use an asset that you don’t own. Two questions arise: which offshore Shell company is going to offer this agreement to Vitol? And has another Shell Group company somehow assumed ownership of these assets without paying SAL for their fair market value?

A fair value transfer must surely be expected to result in a tax obligation for SAL – and therefore revenue for the Australian Tax Office – for any recoupment of tax depreciation or capital gain on disposal of these assets, yet there does not appear to be any disclosure of an expected after-tax effect on SAL. Shell declined to respond to detailed questions for this story but it would be interesting to find out what SAL directors have agreed to in relation to these assets.

This brings us to group fees and charges. These reflect a 33 per cent increase on 2012. Part of this may relate to the assistance the group initially provided to SAL in its proposal to sell the Geelong Refinery, probably including recharges of external consultants. SAL staff would have contributed to the project but generally speaking it is not staffed to do this sort of work.

However, it would certainly be suitable if the group had ceased charging SAL when Vitol approached Shell with its desire to acquire SAL shares. All costs associated with the deal should then be met by the group rather than SAL. We will have to wait and see what SAL, under the new ownership of Vitol, claims in its 2013 and 2014 tax returns.

The base load of fees is still significantly higher than Caltex pays, so the question is, why? Some services are only available from the group, but for those that are available locally, or internationally, are the fees higher than market rates? Can Shell prove that its fees only contain costs actually incurred by SAL in running SAL businesses and that no tax deduction is being sought for fees that are actually a recovery of shareholder related costs?

In Shell’s case, the ATO may already have capped what it will allow as a tax deduction, but it is unlikely that the ATO is ahead of the game with all multinationals.

To gearing, and the total current and non-current loans from the group amount to $1.2 billion, giving a debt to debt and equity ratio of around 50 per cent. This level would be difficult to sustain if SAL were forced to rely on its own credit rating for access to financial markets without direct support from the group in the form of guarantees or negative pledges.

The current component of $227 million is described as a working capital facility. This facility seems to replace trade payables. There is a reduction in trade payables of a similar size.

This facility is probably OK, as long as SAL has been going beyond its terms of trade, but what sort of premium is the group charging on this facility? It is effectively an overdraft account, so the risk premium will be higher than for a non-current revolving credit style of facility.

It would not be a surprise to find Vitol simply replaces all Shell debt with back-to-back replacements. These arrangements are permissible, but the question still needs to be put: why is the group gearing so much lower than that SAL and why it is charging its Australian “branch” operations at a higher rate than it pays to its lenders?

Unlike the Caltex accounts, which break out the service fees from the parent company, Shell does not disclose.

The trading company would be the one providing crude and finished products. The other regional companies would be providing lubricants and other non-fuels products.

The ATO may give the transfer prices on crude and finished product a fair work over – and most multinationals probably negotiate deals with the tax man on what is allowed for tax purposes regardless of price specified in transaction documents. However, the transfer price is not the full story.

This reporter is certainly no expert on petroleum refining to comment with authority, but refining margins are also about yields on the crude supplied. However, buyers can’t always get exactly the crude they want from the market. Refiners are relying on traders to give them what they ask for, if it is available. But who do you trust? If you are a group company, who do you complain to if the group’s traders seem to be underperforming in what they provide to you?

In principle, it would seem to make sense for traders to ensure low-tax refining operations get the best yields if there is room for tweaking. Are Australian refiners happy with what traders have been giving them? It is a fair bet that Caltex refiners would be happier than those of the other majors. Will Vitol prove to be more aggressive towards traders to ensure they get the best deal? Vitol is also a trader with offices in Singapore. They may well supply SAL, but the negotiations will be tougher in future if any supplies come from Shell traders.

Remuneration is a big factor in affecting mind and management. It is interesting to see the note on share-based payments in the SAL accounts.

The shares issued to employees of the SAL group of companies are shares in the ultimate parent company Royal Dutch Shell. The objective here is to ensure that SAL staff who receive these awards retain a focus on the growth in value of the parent rather than SAL as legal owner of Shell’s operations in Australia.

Turning to the comments about the sale of SAL to Vitol, the tax effect of the sale is framed as being indeterminate at the time of the accounts. That is because SAL is currently part of the Shell tax consolidation group with the upstream company SEHAL being the taxpayer.

The effect of the share sale will be that any SAL tax elections taken earlier to rebase the cost of assets as a basis for tax depreciation will no longer be effective. There are likely to be significant tax depreciation recoveries when SAL reverts to being a taxpayer in its own right and it will no longer have any tax consolidation benefits on which to rely. It is not clear how the Vitol transaction deals with this, but you could expect Vitol will look to Shell for economic compensation. The question here is, in what country?

In the past SAL would have effectively derived a cash benefit from the transfer of tax losses to Shell Energy Holdings. In the future, it will have to fully fund the impact of losses because the timing of tax relief will be deferred until it can derive income.

As the sale of Shell’s downstream business will be a share sale, it is reasonable to expect the transfer and exchange of agreements may all occur offshore, in which case the ATO may not have an opportunity to understand the full construct of the deal.

In any transaction of this nature, both buyer and seller will have done their discounted cash-flow modelling (DCF) of after-tax cash flows to arrive at their expected net present values (NPVs) based on the options they perceive to be available. They will have used the modelling of these options in their negotiation of the final deal structure.

The base case for both parties is effectively a straight cash offer for shares. However, the parties clearly intend to retain a relationship after the deal, so there is room for bargaining and for both parties to leverage additional benefit. Tax benefits are an obvious area for leverage.

Vitol proposes to use the Shell brand. It will also probably use its Singapore trader as a supplier. However, as purchaser it is also assuming the business continuity risk in relation to the refinery. Shell is selling out of manufacturing in Australia as it has a more pessimistic view of that business than Vitol, but Vitol is still aware that such a risk exists.

Vitol will probably benefit from a trading margin (to be captured in Singapore) that it would otherwise not have, but may well feel more comfortable with a lower upfront exposure on the purchase price. The question is: has it mitigated its business continuity risk by agreeing to effectively part-pay Shell on a delivered basis?

Shell may be giving up trading margin, but if it can collect licence or franchise fees that wholly or partly offset this loss, it may still be comfortable with a deferred element in the package. The higher the rate paid under franchise or licence agreements, the better Shell may perceive its position.

One possible leverage benefit for Shell of accepting a deferred component may be that it can hold up the rate paid by Vitol (a third party) to other revenue authorities, in support similar fees it seeks from wholly owned companies in other locations. That is, revenue authorities may perceive the Vitol rate as being struck at arms-length, but what is the reality?

This is pure speculation – we are not privy to the deal – but it is worth pointing out the possibility that such transactions can be tweaked to support unrelated transfer pricing activity. There is no imputation that this kind of activity has occurred in this instance. If one’s allegiance, however, is to the central board – as seems to be clearly the case with Shell – it makes sense to use the law to the group advantage rather than the advantage of regional entities.

What is most telling from the accounts for Shell’s upstream business in Australia is the perspective it lends vis-a-vis the true role of its directors. As suggested earlier, that there was only one board meeting for the whole year speaks volumes. Further, two of the rather small board of five directors did not attend the meeting.

Of course there would have been circular resolutions signed off at numerous times during the year, but the dearth of meetings lies in stark contrast to its joint venture partners such as Woodside and BHP.

Woodside’s 2013 report, for instance, shows there were six board meetings. In addition, the various committees also met regularly. By contrast, SEHAL is not obliged to have such formal committees. Bear in mind that Shell is the major shareholder in Woodside and SEHAL is the vehicle that holds this stake.

It is hard not to interpret the minimal role of directors as evidence that Shell’s Australian jobs have been dumbed down to the point where the group would rather appoint more senior Shell representatives than the people it now has as SEHAL’s legally appointed directors.

The fact that no officers of SEHAL are on the Woodside Board to represent SEHAL interests tends to support the view that there are people within Shell global upstream business (resident outside Australia) who may qualify as de facto directors of SEHAL.

Shell directors in Woodside used to be drawn from the directors of Shell Australia Ltd but this changed following the change in the running of the global business. It is now run under one direct line of authority delegation from the board of Royal Dutch Shell rather than the former structure of independent boards for each company.

It is also worth pondering who was actually involved in Shell’s earlier share offer to acquire control of Woodside and its subsequent decision to sell down its Woodside holdings.

Would an Australian have supported proceeding with an attempt to gain control of an Australian icon at the time of looming elections, both federally and in Western Australia, knowing the political implications of the requisite sign-off by the Foreign Investment Review Board (FIRB)?

In earlier days the Australian board would have formally sought the support of its shareholders, but these days decisions are often made and acted upon by more senior people outside Australia in the global operation.

It is also noteworthy that all directors refer to their global titles, including Andrew Smith, who is described as Shell’s Country Chair. This is a sort of figurehead role when the group needs a local spokesperson.

In every country where Shell has several legal entities running different businesses, it also appoints one person to such a role. At the executive level, the likes of finance, human resources and other functions in SAL report directly to their seniors in their global reporting line.

We have said a lot about directors but the point is that, unlike directors of companies listed on the ASX, with obligations to Australian shareholders – that is, a true Australian body corporate – multinational subsidiaries are in a position to structure how they participate in the Australian market and how transactions are structured within the group to minimise exposure to Australian tax.

Google may have taken extreme measures to skirt out of paying tax in this country but traditional multinational players have also taken the lead and shifted in the same direction. Tax has become a virtually optional affair.

SEHAL hedges its foreign currency exposures with the Shell Group. There is nothing wrong with this in principle but are the rates demonstrably at arms-length, or is SEHAL’s cost above market?

As we have demonstrated, there are myriad ways in which a multinational can engage in transfer pricing: to the benefit of the foreign parent and the detriment of the local tax authority, in this case the ATO.

Many of these mechanisms are simply beyond the resources, and sometimes beyond the understanding, of the tax authority.

There is no doubt, however, that this inexorable shift towards the centralisation of the mind and management of multinationals is damaging Australia’s tax base. If the reporting lines and the financial rewards all stem from the global head office, so will the loyalties when it comes to the structuring of tax affairs.